After many decades of economic deprivation and political oppression, socialist regimes in the countries of central and eastern Europe (hereafter C&EE) withered away by the end of 1980s. The end of socialism created an opportunity for people in these countries to develop better institutions. Indeed, new leaders in the region immediately announced plans for institutional restructuring. In the early 1990s, most citizens seemed willing to bear the cost of transition, and free-market ideas enjoyed significant political capital.
The West wasted no time in joining the process of transition in C&EE. As one might have predicted, Western governments, Western "transition experts," international organizations, and more recently the European Union have had significant influence on the scope and patterns of institutional restructuring in C&EE. The World Bank and the International Monetary Fund assumed that controlling institutional changes was their birthright. With the exception of the Czech Republic and Estonia, where Vaclav Klaus and Mart Laar, respectively, initiated "home-grown" free-market reforms, most countries in the region were not left alone to seek and implement their own institutional arrangements. Katharina Pistor found, for example, that the corporate laws developed in various parts of the region resemble those of the countries offering legal assistance. She observes that "the strong similarities of laws that were influenced by identifiable groups of foreign advisors suggest that the contents of legal rules ... were strongly influenced by the group of advisors that dominated in a given country" (2000, 27).
The most oft-repeated message coming from the West in the early 1990s was "privatize, privatize, privatize." Indeed, privatization has been the key policy in post-socialist C&EE. By early 2000, the private sector, consisting primarily of new private (never state-owned) enterprises and privatized state-owned firms, was responsible for more than half of the gross domestic product (GDP) in C&EE, ranging from 80 percent in Hungary to 20 percent in Belarus (Mitra et al. 2000, 6). The consensus is that the new privatize enterprises, which are not the subject of my analysis here, have been the most important contributing factor to this growing share of the private sector (Dabrowski 2002; Laki 2002; Winiecki 2002).
In this article, I analyze the contribution of the privatization of state-owned firms to the institutional restructuring of C&EE. My key finding is that instead of reducing the transaction costs of moving privatized assets to their highest-valued users, the privatization of state-owned firms has slowed down institutional restructuring in C&EE. This relative failure of the privatization of state-owned firms can be attributed to three factors: the influence of neoclassical economics, the absence of decommunization, and the unwillingness of the new elite in the region to recognize and enforce the right of ownership in state-owned assets.
Privatization and Institutional Restructuring
To provide background for the analysis, in this section I briefly identify the major objective of the process of transition in C&EE and some of its most important features.
The transformation of the C&EE countries' socialist economies into capitalist--or free-market, private-property--economies was the new leaders' major stated objective in the early 1990s. (1) Conceptually, genuine capitalism is institutionalized as prescribed by the doctrines of classical liberalism. Its main traits are the rule of law, constitutional democracy, and open markets. (2) The rule of law, which the constitution embodies, guarantees stability and credibility of private-property rights, contractual freedom, and an independent judiciary. Those institutions, often seen as guarantors of so-called negative rights, protect individual members of the community from being forced by a majority rule, decision makers in government, labor unions, and other rent-seeking groups to subordinate the pursuits of their private ends to a desired outcome. James M. Buchanan observes: "[In a rule-of-law state] there is an explicit prejudice in favor of previously existing rights, not because this structure possesses some intrinsic ethical attributes, and not because change itself is undesirable, but for the much more elementary reason that only such prejudice offers incentives for the emergence of voluntary negotiated settlements among [individual members of the community]" (1972, 451-52). Open markets reflect a network of contractual rights and responsibilities based on the rule of law and constitutional democracy. In a world of bounded rationality, open markets provide freely choosing individuals with strong incentives spontaneously to develop, try, and accept institutional arrangements ("rules of the game") that minimize the transaction costs of voluntarily (1) letting resources find their highest-valued uses and (2) accepting the risk associated with the development (innovation) of new opportunities for exchange. By implication, the economic efficiency of the use of resources is expressed in the process through which voluntary interactions are carried out, leading into the unknown. (3) It is not properly to be judged by the attainment of a prestipulated desirable outcome or by its quantitative dimensions. (4) Institutions that offer greater incentives for voluntary interactions are ipso facto more efficient than institutions that provide fewer options for free exchange.
This is not to say that quantitative indices are useless. The point is that quantitative results frequently reflect the consequences of government interference with the freedom to choose (for example, tax breaks for specific investments), and such results are sustainable only as long as that interference lasts. James Gwartney, one of the founders of the Economic Freedom of the World Index, argues that the long-run sustainability of high growth rates depends on how closely a country's institutions conform to the dictates of classical liberalism, not on its government's own efforts to promote growth directly: "The maintenance over a lengthy period of time of institutions and policies consistent with economic freedom is a major determinant of cross-country differences in per capita GDP; cross-country differences in the mean rating during 1980-2000 explain 63.2 percent of the cross-country variations in 2000 per capita GDP" (Gwartney and Lawson 2004, 220, emphasis added).
Although the ideal of capitalism based on the rule of law, constitutional democracy, and open markets has never been realized fully in history, it provides a useful blueprint for evaluating a country's prevailing institutions as well as its proposed institutional reforms. I use here the Index of Economic Freedom, published annually by the Heritage Foundation and the Wall Street Journal since 1995, as a proxy for evaluating the position of individual countries vis-a-vis genuine capitalism. The score of 1 (the best), which no country receives, represents the attainment of genuine capitalism. The best-ranking country in 2005 is Luxemburg, with the score of 1.65. (5) To rank countries in terms of economic freedom, the index uses the factors that undergird genuine capitalism. (6) The index is not a perfect yardstick for measuring how closely individual countries come to genuine capitalism, but along with the Fraser Institute's Economic Freedom of the World Index, it is the best yardstick we have.
One problem is that the index fails to account for differences in the incentive effects of the various elements that compose it. For example, private-property rights in Germany and the United States score 1 (the highest score). Yet, although their legal credibility might be the same, their incentive effects are not. Property rights in Germany do not protect the subjective preferences of their owners as well as property rights do in the United States. They do not protect private-property owners by obstructing legislative and regulatory redistributive measures to the same degree. German law protects private-property rights only to the extent that they serve "human dignity" (as if free markets were not doing precisely that) and the German welfare state. (7)
According to the 2005 Index of Economic Freedom (Miles, Feulner, and O'Grady 2005) fifteen years after the process of transition began in C&EE, only one country in the region is a free country: Estonia. Nine countries are mostly free (Lithuania, Lawia, Czech Republic, Slovakia, Hungary, Slovenia, Poland, Bulgaria, and Albania). Seven countries are mostly unfree (Croatia, Macedonia, Moldova, Russia, Ukraine, Romania, Bosnia and Herzegovina). Belarus is repressed, and Serbia and Montenegro is not rated.
The Role of Neoclassical Economics
At the outset of the economic reforms in the early 1990s, the majority of Western advisors, mostly economists working for international organizations, and the new leaders in C&EE were more familiar with the prevailing mainstream economics--neoclassical economics--than with other methods of economic analysis, such a the New Institutional School, Austrian economics, and public choice. Intentionally or not, the process of transition in general and the privatization of state-owned firms in particular have reflected this familiarity with or adherence to the neoclassical way of thinking. Examples include the so-called Washington consensus, Sachs's "big bang" approach to reforms everywhere, Balcerowicz's "big bang" in Poland, and Mencinger's gradualism in Slovenia. (8)
Neoclassical economics converts the desire for more utility, a basic trait of observed human behavior, into the maximization paradigm and analyzes the economic outcomes of that behavior in a hypothetical world of nonattenuated private ownership and insignificant (or exogenously determined) transaction costs. (9) The maximization paradigm identifies a series of equilibria, which, in turn, are...